In a bit of synchronicity, two items, focusing on different aspects of our continuing credit woes, illustrate how the Fed is acting like the drunk looking under a streetlamp for his keys, because the light is good there, rather than where he lost them. The central bank’s version of this behavior is to continue to focus on the most superficial aspects of the crisis, even though those measures have not produced any lasting success (indeed, some have backfired) rather than go after root causes. In the initial phases, this response would be reasonable; you need to stabilize the patient before you operate, but at this juncture, the Fed’s disinclination to address obvious causes of instability is mystifying.
Let’s look at the two faces of this coin. The first is market commentary, “TAF results are disconcerting,” from David Kotok of Cumberland Advisors. Note that Kotok by predisposition is more optimistic about the future than yours truly, and is well plugged into the Fed, so a note of this sort signals real concern:
The Term Auction Facility (TAF) results were not encouraging. Neither were they substantially discouraging but, at the margin, they actually worsened. It is clear that the demand for liquidity in the banking system is still intense….
The minimum bid in the most recent auction (April 21) was 2.05%. In the previous auction (April 7) the minimum bid was 2.11%. In the most recent auction the stop out rate which was awarded to all bidders was 2.87%. In the previous auction the awarded rate was 2.82%. So the minimum bid went down while the award rate went up. The spread widened by 11 basis points. That is not suggestive of a market returning to normalcy….
We should also note that the TAF auction rate was very close to LIBOR. And LIBOR has been the subject of much negative press recently as followers of money markets know.
Our conclusion is that credit markets are still dysfunctional and the process of normalcy restoration has a long way to go….
This latest auction cannot give any comfort to the Fed. In the reaction over LIBOR, the Fed watched market driven interest rates rise. LIBOR is the world’s most important commercial interest rate reference. It went up even as the Fed tried to ease rates down. Our central bank sees market driven interest rates moving in the opposite direction of the path that the central bank desires. This is a message that the Fed’s policy is failing.
We expect the Fed to cut interest again at the meeting at the end of this month. We also believe that the Fed will have to enlarge the TAF auction and also add more extended terms to the facility. The sooner the Fed implements those changes the sooner the credit markets will start to heal and return to more normal spreads.
We offer this final note. Various measure of spread based risk premiums have been at extraordinary levels since last June when the turmoil started. These widened spreads are taking an economic toll. We expect that the Fed will persist until it gets them to narrow.
If the Fed fails, we will have a difficult and protracted deflationary recession. If the Fed succeeds, the slowdown will be shorter and shallower….But we must admit that when we see a TAF auction result like we just saw, we become just a little more worried.
Now this is by all accounts a very savvy individual, yet what does he recommend? Persisting in, nay redoubling, a failed strategy. That is not a sign of intelligence. And his thinking may well reflect Fed input.
Consider the alternative view, which is more persuasive, and fits the fact set of the broader problem better, but also makes clear that the path to resolution is full of pitfalls and complications.
John Dizard, in “The jerry-built derivative structure will have to go,” argues that thing will not get better until OTC credit derivatives are dismantled. Lets’ face it, banks are unwilling to lend to each other for perfectly good reason. They know how sizeable and prone to mishap their own exposures are. Its’ a no-brainer that a significant proportion of their counterparties are in at least as bad shape as they are.
The very fact that the Fed orchestrated a rescue of Bear, who should otherwise have been too small to fail save for the size of its credit default swaps book indicates that the Fed on some level recognizes that this is a major problem. Yet there seems to be no institutional will to confront it. Admittedly, this is hugely hairy problem, but I suspect the real impediment is that confronting the industry requires considerable tough-mindedness, a quality notably lacking at the US central bank.
But further injections of liquidity in lieu of addressing the fundamental issue is akin to adminsitering more morphine to treat the pain of intestinal blockage. It not only fails to address a the real ailment, but the higher doses are every bit as dangerous as the untreated disease.
From the Financial Times:
Credit market people and their regulators have been so preoccupied with defusing the more visible unexploded bombs in Wall Street that the more serious, long-term structural problems have been put off for later attention. Much later attention, in the case of those structural problems that could cause career or biography damage for senior policy people.
The epicentre of all the problems is the financial system’s dependence on over-the-counter derivative contracts, which made possible all the other bubbles that have been revealed and will be revealed soon. I believe that it will be necessary to dismantle carefully most of this jerry-built structure, and replace the bank-to-bank-to-dealer-to-dealer contract structure with central clearing houses for risk instruments.
Given that these are international markets of unimaginable size, this will take multilateral official co-operation to put into effect. The US government’s involvement in the Bear Stearns work-out, far from marking the end of the credit crisis, shows how any resolution to the larger systemic issues will need to have official backing.
You will notice that through all the perturbations of the financial markets over the past nine months, there have been no problems with the operations of the centrally cleared futures and options exchanges.
The character and integrity of the participants in these exchanges – the speculators, hedgers and intermediaries – is no better than you would find in the over-the-counter markets. But the scope for wrongdoing is far less, since every day, every hour, these people’s assets and liabilities are more or less accurately marked, and any deficiencies in their accounts have to be made up, or the accounts liquidated.
There were advantages of the over-the-counter markets for credit default swaps, interest rate swaps, and equity derivatives. OTC derivatives required less market-making capital than exchange-traded instruments, and the conserved capital could support more real economic activity.
OTC derivatives are more flexible than exchange-traded instruments, so they can be written for the exact requirements of the counterparties. That in turn made further capital savings possible, since (apparently) precisely hedged positions did not need the same level of reserves.
But it all got too big. The model did not take sufficient account of financial markets invariably taking any sensible innovation to senseless extremes.
I’ve been reading the Massachusetts state government’s administrative complaint against Bear Stearns Asset Management, and its administration of the now bankrupt High Grade Structured Credit Strategies Fund, and the Enhanced Leverage Fund. The complaint has been filed in order to commence court proceedings against Bear Stearns.
No one can believe that Bear Stearns Asset Management was uniquely self-serving and careless; in fact, it may have been better than many of its counterparts on the Street. It’s just that the poor behaviour of the Bear management is now a matter of public record….
For example, according to the Massachusetts complaint, related party transactions were poorly administered. “The result of this poor conflict management was that hundreds of transactions did not obtain the approvals required by federal law and promised in the offering documents,” the complaint claims.
Also, mis-priced derivatives instruments were allegedly transferred, or “novated” in the legal jargon, on the investors by Bear management. The transfers of value took place at cost rather than market value, the complaint claims, not to the advantage of the investors in the funds.
Referring to just two sets of transactions, the complaint says, “on information and belief, the net decrease in value to the funds as a result of the May 3 novation of credit default swaps . . . was $6,199,587 [and] . . . as a result of the May 8 novation of credit default swaps was $10,9111,290”.
Multiply this sort of behaviour across the thousands of funds, vehicles, accounts and so on, around the world, and you see the scale of the problem. Exchange-traded and centrally cleared instruments may be less flexible and more capital intensive, but at least everyone sees the same prices.
How did this come to pass? Christopher Whalen of Institutional Risk Analytics blames the Federal Reserve and other regulators. “The Fed knows that banking is a commodity business, and by allowing the banks to migrate off the exchanges they allowed them to enhance their profitability. The Fed people knew risk management was a problem, but they thought they could deal with all the risks created by the over-the-counter model through the Basel 2 rules.”
I guess not.